11 0 Project Analysis and Evaluation

1 Key Concepts and Skills  Understand forecasting risk and sources of value  Understand and be able to do scenario and sensitivity analysis  Understand the various forms of break- even analysis  Understand operating leverage  Understand capital rationing

2 Chapter Outline  Evaluating NPV Estimates  Scenario and Other What-If Analyses  Break-Even Analysis  Operating Cash Flow, Sales Volume, and Break-Even  Operating Leverage  Capital Rationing

3 Evaluating NPV Estimates  NPV estimates are just that – estimates  A positive NPV is a good start – now we need to take a closer look Forecasting risk – how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk Forecasting risk – how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk Sources of value – why does this project create value? Sources of value – why does this project create value?

4 Scenario Analysis  What happens to the NPV under different cash flow scenarios?  At the very least look at: Best case – high revenues, low costs Best case – high revenues, low costs Worst case – low revenues, high costs Worst case – low revenues, high costs Measure of the range of possible outcomes Measure of the range of possible outcomes  Best case and worst case are not necessarily probable, but they can still be possible

5 New Project Example  Consider the project discussed in the text  The initial cost is $200,000 and the project has a 5-year life. There is no salvage. Depreciation is straight-line, the required return is 12%, and the tax rate is 34%  The base case NPV is 15,567

6 Summary of Scenario Analysis Scenario Net Income Cash Flow NPVIRR Base case 19,80059,80015, % Worst Case -15,51024, , % Best Case 59,73099,730159, %

7 Sensitivity Analysis  What happens to NPV when we vary one variable at a time  This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV  The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation

8 Summary of Sensitivity Analysis for New Project Scenario Unit Sales Cash Flow NPVIRR Base case ,80015, % Worst case ,200-8, % Best case ,40039, %

9 Simulation Analysis  Simulation is really just an expanded sensitivity and scenario analysis  Monte Carlo simulation can estimate thousands of possible outcomes based on conditional probability distributions and constraints for each of the variables  The output is a probability distribution for NPV with an estimate of the probability of obtaining a positive net present value  The simulation only works as well as the information that is entered and very bad decisions can be made if care is not taken to analyze the interaction between variables

10 Making A Decision  Beware “Paralysis of Analysis”  At some point you have to make a decision  If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project  If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project

11 Break-Even Analysis  Common tool for analyzing the relationship between sales volume and profitability  There are three common break-even measures Accounting break-even – sales volume at which net income = 0 Accounting break-even – sales volume at which net income = 0 Cash break-even – sales volume at which operating cash flow = 0 Cash break-even – sales volume at which operating cash flow = 0 Financial break-even – sales volume at which net present value = 0 Financial break-even – sales volume at which net present value = 0

12 Example: Costs  There are two types of costs that are important in breakeven analysis: variable and fixed Total variable costs = quantity * cost per unit Total variable costs = quantity * cost per unit Fixed costs are constant, regardless of output, over some time period Fixed costs are constant, regardless of output, over some time period Total costs = fixed + variable = FC + vQ Total costs = fixed + variable = FC + vQ  Example: Your firm pays $3000 per month in fixed costs. You also pay $15 per unit to produce your product. Your firm pays $3000 per month in fixed costs. You also pay $15 per unit to produce your product. What is your total cost if you produce 1000 units?What is your total cost if you produce 1000 units? What if you produce 5000 units?What if you produce 5000 units?

13 Average vs. Marginal Cost  Average Cost TC / # of units TC / # of units Will decrease as # of units increases Will decrease as # of units increases  Marginal Cost The cost to produce one more unit The cost to produce one more unit Same as variable cost per unit Same as variable cost per unit  Example: What is the average cost and marginal cost under each situation in the previous example Produce 1000 units: Average = 18,000 / 1000 = $18 Produce 1000 units: Average = 18,000 / 1000 = $18 Produce 5000 units: Average = 78,000 / 5000 = $15.60 Produce 5000 units: Average = 78,000 / 5000 = $15.60

14 Accounting Break-Even  The quantity that leads to a zero net income  NI = (Sales – VC – FC – D)(1 – T) = 0  QP – vQ – FC – D = 0  Q(P – v) = FC + D  Q = (FC + D) / (P – v)

15 Using Accounting Break-Even  Accounting break-even is often used as an early stage screening number  If a project cannot break even on an accounting basis, then it is not going to be a worthwhile project  Accounting break-even gives managers an indication of how a project will impact accounting profit

16 Accounting Break-Even and Cash Flow  We are more interested in cash flow than we are in accounting numbers  As long as a firm has non-cash deductions, there will be a positive cash flow  If a firm just breaks even on an accounting basis, cash flow = depreciation  If a firm just breaks even on an accounting basis, NPV < 0

17 Example  Consider the following project A new product requires an initial investment of $5 million and will be depreciated to an expected salvage of zero over 5 years A new product requires an initial investment of $5 million and will be depreciated to an expected salvage of zero over 5 years The price of the new product is expected to be $25,000 and the variable cost per unit is $15,000 The price of the new product is expected to be $25,000 and the variable cost per unit is $15,000 The fixed cost is $1 million The fixed cost is $1 million What is the accounting break-even point each year? What is the accounting break-even point each year? Depreciation = 5,000,000 / 5 = 1,000,000Depreciation = 5,000,000 / 5 = 1,000,000 Q = (1,000, ,000,000)/(25,000 – 15,000) = 200 unitsQ = (1,000, ,000,000)/(25,000 – 15,000) = 200 units

18 Sales Volume and Operating Cash Flow  What is the operating cash flow at the accounting break-even point (ignoring taxes)? OCF = (S – VC – FC - D) + D OCF = (S – VC – FC - D) + D OCF = (200*25,000 – 200*15,000 – 1,000,000 -1,000,000) + 1,000,000 = 1,000,000 OCF = (200*25,000 – 200*15,000 – 1,000,000 -1,000,000) + 1,000,000 = 1,000,000  What is the cash break-even quantity? OCF = [(P-v)Q – FC – D] + D = (P-v)Q – FC OCF = [(P-v)Q – FC – D] + D = (P-v)Q – FC Q = (OCF + FC) / (P – v) Q = (OCF + FC) / (P – v) Q = (0 + 1,000,000) / (25,000 – 15,000) = 100 units Q = (0 + 1,000,000) / (25,000 – 15,000) = 100 units

19 Three Types of Break-Even Analysis  Accounting Break-even Where NI = 0 Where NI = 0 Q = (FC + D)/(P – v) Q = (FC + D)/(P – v)  Cash Break-even Where OCF = 0 Where OCF = 0 Q = (FC + OCF)/(P – v) (ignoring taxes) Q = (FC + OCF)/(P – v) (ignoring taxes)  Financial Break-even Where NPV = 0 Where NPV = 0  Cash BE < Accounting BE < Financial BE

20 Example: Break-Even Analysis  Consider the previous example Assume a required return of 18% Assume a required return of 18% Accounting break-even = 200 Accounting break-even = 200 Cash break-even = 100 Cash break-even = 100 What is the financial break-even point? What is the financial break-even point? Similar process to that of finding the bid priceSimilar process to that of finding the bid price What OCF (or payment) makes NPV = 0?What OCF (or payment) makes NPV = 0? N = 5; PV = 5,000,000; I/Y = 18; CPT PMT = 1,598,889 = OCF N = 5; PV = 5,000,000; I/Y = 18; CPT PMT = 1,598,889 = OCF Q = (1,000, ,598,889) / (25,000 – 15,000) = 260 unitsQ = (1,000, ,598,889) / (25,000 – 15,000) = 260 units  The question now becomes: Can we sell at least 260 units per year?

21 Operating Leverage  Operating leverage is the relationship between sales and operating cash flow  Degree of operating leverage measures this relationship The higher the DOL, the greater the variability in operating cash flow The higher the DOL, the greater the variability in operating cash flow The higher the fixed costs, the higher the DOL The higher the fixed costs, the higher the DOL DOL depends on the sales level you are starting from DOL depends on the sales level you are starting from  DOL = 1 + (FC / OCF)

22 Example: DOL  Consider the previous example  Suppose sales are 300 units This meets all three break-even measures This meets all three break-even measures What is the DOL at this sales level? What is the DOL at this sales level? OCF = (25,000 – 15,000)*300 – 1,000,000 = 2,000,000 OCF = (25,000 – 15,000)*300 – 1,000,000 = 2,000,000 DOL = 1 + 1,000,000 / 2,000,000 = 1.5 DOL = 1 + 1,000,000 / 2,000,000 = 1.5  What will happen to OCF if unit sales increases by 20%? Percentage change in OCF = DOL*Percentage change in Q Percentage change in OCF = DOL*Percentage change in Q Percentage change in OCF = 1.5(.2) =.3 or 30% Percentage change in OCF = 1.5(.2) =.3 or 30% OCF would increase to 2,000,000(1.3) = 2,600,000 OCF would increase to 2,000,000(1.3) = 2,600,000

23 Capital Rationing  Capital rationing occurs when a firm or division has limited resources Soft rationing – the limited resources are temporary, often self-imposed Soft rationing – the limited resources are temporary, often self-imposed Hard rationing – capital will never be available for this project Hard rationing – capital will never be available for this project  The profitability index is a useful tool when a manager is faced with soft rationing

24 Quick Quiz  What is sensitivity analysis, scenario analysis and simulation?  Why are these analyses important and how should they be used?  What are the three types of break-even and how should each be used?  What is degree of operating leverage?  What is the difference between hard rationing and soft rationing?

11 25 End of Chapter

26 Comprehensive Problem  A project requires an initial investment of $1,000,000, and is depreciated straight-line to zero salvage over its 10-year life. The project produces items that sell for $1,000 each, with variable costs of $700 per unit. Fixed costs are $350,000 per year.  What is the accounting break-even quantity, operating cash flow at accounting break-even, and DOL at that output level?